Company X is currently all-equity financed and has no cash on hand. The company has assets in

place and a single investment opportunity. The value of the assets in place depends on whether a

recent cost-cutting initiative at the company was successful or not. Assets in place are worth $16M

if the initiative was successful and $12M if it was unsuccessful. The CEO of the company knows

whether the cost-cutting initiative was successful or not, but investors in the market do not.

Investors believe that there is a 50% chance that it was successful and a 50% chance that it was

unsuccessful. The companys investment opportunity entails investing $8M today, which will

generate future cash flows with a present value of $12M (so the NPV of the project is $4M). The

market is aware of the existence of the investment opportunity as well as its cost and payoff.

2a) Suppose that you, as a CEO, care only about maximizing the value of current shareholders

claims. You have the following choices:

i) Turn down the investment.

ii) Issue debt to raise $8M and invest. If the company issues debt, it will incur $8M of

financial distress costs, even if the company does not actually default.

iii) Issue equity to raise $8M and invest.

If you were the CEO of Company X, which one of these three options would you choose if you

knew that the cost-cutting initiative was successful, and why? Which one of these options would

you choose if you knew the cost-cutting initiative wasunsuccessful, and why?

Hint: Notice that the company has a highly profitable growth opportunity and that the financial

distress costs are quite high. In this case, the market is likely to expect that the company would

issue equity even if its cost-cutting initiative had been successful (rather than passing up the project

or issuing debt, which will generate financial distress costs). Hence, the market will price equity

issues as coming from an average type (i.e., investors expect the company to issue equity

whether its cost-cutting was successful or not).

2b) Suppose that everything is exactly as in part (a), except that the distress costs are $80,000

instead of $8M. If you were the CEO of Company X, which one of the three options would you

choose if you knew that the cost-cutting initiative wassuccessful, and why? Which one would

you choose if you knew the cost-cutting initiative wasunsuccessful, and why?

Hint: Notice that the company still has a highly profitable growth opportunity in this case, but the

financial distress costs are quite small. In this case, the market is likely to expect the company to

finance the project by issuing debt rather than selling undervalued equity if its cost-cutting

initiative was successful. Hence, the market will price equity issues as coming from a company

that had an unsuccessful cost-cutting initiative.

2c) Suppose the company has 1M shares outstanding. Compute the change in the price of the

shares if the company issues equity in the scenarios described in parts (a) and (b) and explain the

difference. Hint: The price today should reflect the expected value of Company X. This value is

the average of the value of the company if its cost-cutting was successful and the value if its costcutting

was unsuccessful since we do not know today whether cost-cutting was successful or not.

You should have already computed these values in parts (a) and (b).